Download Quiz 3 Solution Set 14.02 Macroeconomics May 23, 2006

Quiz 3 Solution Set
14.02 Macroeconomics
May 23, 2006
I. Answer each as True, False, or Uncertain, and explain your choice.
1. If individuals are forward-looking, current money demand should depend on both
current and expected future nominal interest rates.
Ans:
False. The opportunity cost of holding money today depends on only the current
nominal interest rate. If nominal interest rates were to change in the future,
there would be ample time to adjust money balance then, so expected changes in
interest rate should not affect money balance today.
2. A monetary expansion always shifts up the LM curve and leaves the IS curve
unchanged.
Ans:
False. A monetary expansion can also shift the IS curve if it leads financial
investors, firms and consumers to revise their expectations of future interest rates
and output.
3. A fiscal contraction always reduces output in the short run.
Ans:
False. A fiscal contraction improves the budget balance, and leads to a lower
interest rate and a higher investment in the medium run. Hence, it may actually
lead to an economic expansion in the short run, as firms and households update
their expectations on future output and future interest rates.
4. Under fixed exchange rates, fiscal policy is more powerful in moving output than
it is under flexible exchange rates.
Ans:
True. Under fixed exchange rates, the central bank must accommodate a fiscal expansion (contraction) by undertaking a simultaneous monetary expansion
(contraction). Both policies move output in the same direction.
5. The effect of fiscal policy on output is stronger in an open economy with fixed
exchange rates than in a closed economy.
Ans:
Uncertain. For the same argument provided in (4), this statement seems to be
true. However, part of the effects on domestic demand falls on foreign goods in
an open economy, while all the effects falls on domestic goods in a closed economy.
The former makes fiscal policy stronger in an open economy with fixed exchange
rates than in a closed economy, and the latter makes it weaker, so the comparison
of the overall effect is ambiguous.
II. Long Questions:
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1. Expectations:
Consider the following description of an economy:
IS:
LM:
Y = A(Y, r, T, Y 0e , r0e , T 0e ) + G
M
= Y L(r)
P
There are two periods: the current period (the short run) and the future period
(the medium run). Primes denote future period values, and “e” denotes an
expectation. For simplicity, assume that current and future inflation, actual and
expected, are equal to zero, so the real and the nominal interest rates are equal.
Assume initially that Y = Y 0e = Yn = Yn0 , r = r0e = rn , T = G = T 0e = T̄ .
In words, output, current and expected, is equal to the natural level of output,
which is itself constant. The real interest rate, current and expected, is equal to
the natural interest rate — the real interest rate associated with the natural level
of output. Taxes, current and expected, are constant, and equal to government
spending.
Now suppose that a major technological discovery is made, which leads people
and firms to expect a higher natural level for output in the future: Yn0 increases,
and so does Y 0e . Assume r0e = rn0 is unchanged, and so are taxes, current and
expected.
a. What will be the effect on output (Y ) and the interest rate (r) in the current
period (or in the short run)? Show the result graphically. Explain in words.
Ans:
See Figure 1.
Figure 1:
An increase in expected future output boosts the aggregate demand today.
Holding everything else constant, the IS curve shifts out, while the LM curve
stays the same. As a result, both output and the interest rate increase in
the short run.
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b. Suppose you are in charge of monetary policy. What should you do? (Hint:
You want to increase the interest rate through a contractionary open market
operation. Why?)
Ans:
The major technological discovery is expected to increase the natural level of
output in the future but leaves the current Yn unchanged. As current output
Y increases and exceeds Yn , inflation will accelerate according to the Phillips
curve. To restrain inflation, the central bank should tighten the money
supply. As a result, the LM curve shifts up, leading to a further increase in
r while keeping Y at its natural level.
2. The Mundell-Fleming Model:
Consider the following description of an open economy in the short run:
IS:
LM:
UIP:
Y = C(Y − T ) + I(i, Y ) + G + NX(Y ∗ , Y, E)
M
= Y L(i)
P
(1+i)
e
E = (1+i
∗ ) Ē
a. Characterize graphically the equilibrium, and the equilibrium values of Y, i, E
for given values of T, G, Y ∗ , M
, i∗ , Ē e .
P
Ans:
See Figure 2.
Figure 2:
Now suppose that investors in the foreign exchange market start expecting a large
depreciation of the domestic currency (e.g., the US dollar) in the future.
b. Characterize graphically the effects on Y, i and E. Explain in words.
Ans:
See Figure 3.
As investors change their expectations on future exchange rate, specifically
0
Ē e < Ē e , the UIP curve shifts up. Expecting a large depreciation of the
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Figure 3:
domestic currency, investors must either require a higher interest rate on
domestic bonds or start selling off domestic assets. An expected depreciation
precipitates an immediate depreciation. The depreciation of the domestic
currency shifts the IS curve to the right, leading to higher Y and higher i.
The increase in interest rate prevents further selling of domestic assets and
thus restrains the current depreciation. As a result, Y increases, i increases,
and E decreases.
Assume that initially (before the change in expectations), output was equal to its
natural level Yn .
c. How can you use monetary policy to keep output unchanged? What are the
implications for the interest rate and for the exchange rate?
Ans:
Based on answers to part (b), the central bank should tighten money supply,
which shifts up the LM curve and thus can keep output at its natural level Yn .
A monetary contraction further increases i, in other words, further reduces
the interest rate differential, and thus reduces the initial depreciation (i.e., E
still decreases but by less than in part (b)). However, no monetary policy
can perfectly defend a currency (i.e., no change in E) while keeping output
intact at the same time.
d. How can you use fiscal policy to keep output unchanged? What are the
implications for the interest rate and for the exchange rate?
Ans:
Based on answers to part (b) , fiscal policy can be used to move the IS curve
back to the left, so that the new IS curve and the LM curve intersect at the
original equilibrium (Yn , i). As a result, output remains the same, and so
does the interest rate. This implies that the expected depreciation will occur
immediately, and the exchange rate will fall by more than in part (b).
e. Suppose that there is initially a large trade deficit (e.g., the United States).
Would you want to use fiscal or monetary policy in this case?
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Ans:
Given a large trade deficit, part (c) and (d) suggest that fiscal policy should
be more favorable, because a large depreciation of the domestic currency can
help improve the trade balance.
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